The Real Competition for Cash

There is little disagreement in the life science start-up community that the demand for capital exceeds the supply. You would expect entrepreneurs to respond by jockeying and undercutting for position, but, in my experience, this does not really seem to be the case. Most life science entrepreneurs tend to be more collaborative than competitive, and are willing to assist others by providing advice, connections, etc. Perhaps this is because life sciences is an inherently collaborative sector (i.e. via licensing, co-development, co-marketing, etc.) built on strong relationships, or because the degree of difficulty involved contributes to mutual humility and respect. Or maybe this is because the diversity of start-ups, in terms of science and business models, is considerably vast, meaning that not all entrepreneurs appeal to the same crowd of investors. Regardless of the reasons, there is a competition for cash, but it is not at the entrepreneur-level!

As I discussed in a previous article, as difficult as it is for an entrepreneur to raise a round, it is considerably more difficult for a venture capitalist to raise a fund. Funds are raised from institutional investors (e.g. pension plans, endowments, high net worth family offices, etc.) that are responsible for managing upwards of hundreds of millions or billions of dollars. It is the goal of the fund to achieve a desired return based on some acceptable level of risk, and that risk/reward tolerance determines the asset mix. Asset classes include cash and foreign currency, debt, bonds, publicly-traded equities, private equity, and venture capital. Venture capital is widely considered the riskiest asset class, in that funds are typically locked for ten years and invested in innovative companies with the intent of hitting a home run. The desired rate of return for a fund is usually north of 20% per year, meaning the fund must return at least a 5X return on capital! Failure to achieve these high returns results in failure to raise subsequent funds!

Based on this, the real competition for cash happens at the venture capital-level. First, venture capitalists compete with other asset classes, particularly public and private equities. To the extent that the S&P 500 index outperforms a venture capitalist, institutional investors will invest in publicly-traded blue chips. Second, life science venture capitalists compete with those in software, electronics, communications, cleantech and other advanced technologies for capital. Again, to the victor goes the spoils, and the best performing venture capitalists are rewarded with additional capital.

As a Canadian, I have written before about how the performance of natural resources (i.e. “old economy”) has hindered the country’s pursuit of innovation. However, it is equally frustrating that much of the country’s capital that is earmarked for innovation, really does not advance innovation. According to the most recent Industry Canada Venture Capital Monitor (Q3 2012), venture capital investment in information technologies was more than double that of life sciences ($208 million versus $93 million). In my opinion, innovation consitutes those accomplishment that result in sustained economic and social growth. People can survive without Instagram, Pinterest, and Facebook, much more so than drugs, diagnostics and devices. However, the proliferation of these types of companies should be expected, as recent venture returns on information technology as well as media & communications have been well above all others.

The unfortunate reality is that a person is likelier build a billion dollar company by writing code than by treating cancer. Money is a phenomenally powerful incentive, for as long as life science is less profitable than other advanced technologies, venture capitalists will struggle to raise funds, and entrepreneurs will be underfunded. The fate of human health care will be decided by profit!